Relationship between developed and emerging markets

The emerging markets are not yet immune from developments in the developed economies.

Readers may be aware of the word "decoupling" being increasingly used by analysts to explain the difference in economic and financial performance between the developed markets, in particular the United States, and the emerging markets, particularly those in Asia.  The fact is that the emerging markets in Asia have continued to record strong economic growth, while the US economy seems to be faltering.  Financial markets in Asia have also out-performed those in the US by a substantial margin, and this was particularly obvious in 2007.

I am a little sceptical about the somewhat excessive use of the word, which suggests that the emerging markets in Asia are no longer dependent upon the US, economically or financially.  While intra-regional trade in Asia has grown a lot more rapidly than that between Asia and the US, indicating that Asian economies are becoming more inter-dependent, the US economy is still the largest in the world, representing about 20% of global GDP, although this ratio has been slowly declining.  And exports to the US are mostly finished consumer products, while a significant part of the intra-regional trade in Asia involves intermediate products, since different jurisdictions specialise in different processes in the manufacture of the finished goods.  Information technology has also improved the logistics of production and trade to such an extent that now it takes less time for the macroeconomic conditions of an economy to affect its trading partners through the trade channel.  It is therefore difficult to envisage a situation where the emerging markets in Asia would become immune from, say, a significant economic slowdown or a recession in the US, as "decoupling" might suggest.  It is of course a matter of degree.  And we should observe that, while there is a sharp focus on the economic outlook for the US, its economic performance up to the third quarter of 2007, when the sub-prime crisis gathered momentum, was still quite impressive.

Despite the occasional occurrence of sharp world-wide movements in asset prices, the difference in financial-market performance between the US and the emerging markets in Asia has been large enough recently to warrant the use of the word "decoupling".  But I think there is a need to distinguish between the short term and the long term.  The sub-prime crisis originated in the US and thankfully, because securitisation has not yet caught on here, there is no similar crisis in Asia, although financial institutions and investors are exposed to losses in sub-prime structured products to varying degrees.  The resulting credit tightness, or credit crunch as an increasing number of analysts are calling it, is also very much a phenomenon specific to the US and the developed markets, adversely affecting sentiment in their financial markets.  Obviously this was enough to generate shifts of global investment funds from the developed markets to the emerging markets, which was further encouraged by actual or anticipated exchange rate movements.  The World Bank, for example, estimated that capital flows to East Asia in 2007 amounted to US$170 billion.  As a result, the equities markets in the emerging economies have outperformed those of the developed markets by more than 30% in 2007.

But in the long term, financial market performance reflects economic performance.  Financial globalisation, encouraged by financial liberalisation in the large developing nations, seems irreversible, and this, theoretically at least, points to the possibility of increasing correlation among financial markets across developed and emerging economies rather than the opposite, as global investment portfolios naturally seek long-term benefits through diversification.  Although there is still a lack of empirical evidence of increasing correlation, I believe that this just reflects the fact that financial liberalisation is still underway in the developing economies, notably Mainland China.

So, while investors gain from the good performance of the emerging markets in Asia, and many apparently buy the argument of financial "decoupling", we should all bear in mind the possibility of this being only a short-term phenomenon, at least to the extent that the out-performance is not explained by better economic fundamentals and prospects.  We should note, for example, the dependence of some emerging markets on external financing mobilised by global financial institutions based in the developed markets, which are now experiencing the credit crunch.  The preoccupation of these global financial institutions with tackling the sub-prime crisis may result in a deterioration of external financing conditions for these emerging markets, and there may be wider economic and financial implications for them.
　

Joseph Yam
31 January 2008

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